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Author's note:This is this first article in a five-part series on estate planning. Part one deals with minimizing death taxes. In part two, we’ll discuss how to avoid the costs, delays and publicity associated with probate in the event of your death or incapacity. Part three will look at ways to set forth your dispositive wishes (i.e., who gets what, when and how). In part four, we’ll examine how to coordinate the myriad technical rules relating to IRAs and other retirement plans with your overall estate plan. And in part five, we’ll discuss advance directives regarding your medical decisions upon incapacity, including end-of-life decisions.

Minimizing death taxes

Federal estate taxes
A death tax is technically a tax on the transfer of property to others. Federal estate taxes were first collected in 1916. Now, as part of 2001 tax legislation, the federal estate tax is eliminated for persons dying in 2010, but is reinstated in 2011. On January 1, 2011, the estate tax exemption — which was $3.5 million in 2009 — becomes $1 million, and the top tax rate — which was 45 percent in 2009 — becomes 55 percent. However, it's likely that Congress will reinstate the federal estate tax before 2011, possibly retroactively. Among the various bills being considered by Congress are exemptions of $3.5 million to $5 million per decedent, and top tax rates from 35 percent to 45 percent.

It is estimated that with an estate tax exemption of $3.5 million, less than one-half of one percent of all Americans will have to pay estate taxes. And with proper planning, married couples can "double" the estate tax exemption amount. Moreover, since 1981, there have been no estate taxes on transfers between spouses. Thus, for married couples with large estates, the estate tax can be deferred until the death of the surviving spouse.

State death taxes
Many states impose their own estate tax or inheritance tax. You should check your local law to see if your state has a death tax. The problem is that most states with a death tax have not raised their exemptions to match the federal exemptions. This means that many decedents who escape the federal estate tax could still get hit with a state death tax. There is a deduction against the federal estate tax for any state death taxes paid, but that only helps wealthy taxpayers whose estates exceed the federal estate tax exemption.

Your estate includes everything you own — your residence, other real estate, bank accounts, investments, retirement plans, IRAs, life insurance and personal belongings. For death tax purposes, it's the fair market value of the asset on the date of death that is subject to tax. Even though the death proceeds of life insurance are income tax free to the beneficiary of the policy, the face amount of the policy is part of the insured's estate, if the insured owned the policy.

Reducing death taxes
While federal and state death taxes can add up against large estates, these taxes can be reduced or eliminated if you plan ahead. The only way to reduce death taxes is to make lifetime gifts to family members and/or testamentary bequests to qualified charities. Under the federal "gift tax annual exclusion", you can gift up to $13,000 (adjusted for inflation) annually to as many persons as you like. A married couple can gift $26,000 annually per donee. Annual exclusion gifts not only remove the gifted property from your estate, they remove the future income and appreciation on the gifted property, as well.

In addition to the $13,000 annual gift tax exclusion, you can gift $1 million ($2 million for a married couple) during your lifetime. Any amount you use out of your $1 million lifetime gift tax exemption counts against your estate tax exemption. By using your lifetime gift tax exemption, you are removing the future income and appreciation on the gifted property from your estate.

While you receive no income tax deduction for making gifts (except gifts to qualifying charities), the donee does not have to report the gift as income. But, if the gifted property produces income, the donee must report any income produced after the gift. If the gift consists of property other than cash, your cost basis and holding period transfer over to the donee. You may need to file a gift tax return (Form 709) to report your gifts. Thus, you should always consult with your accountant or other tax advisors when making gifts.

Gifts in trust
For larger gifts, it's advisable to create estate tax protected, creditor protected and divorce protected trusts to receive gifts on behalf of your donees. Though in trust, an adult beneficiary can still control the funds as the trustee. In fact, a beneficiary can be given nearly all the rights, benefits and control over the trust property that a person would have with outright ownership, on top of tax, creditor and divorce protection not available with outright ownership.

These trusts are sometimes referred to as “beneficiary-controlled” trusts. They can be created during the grantor's lifetime, or at the death of the grantor (or the survivor of the grantor and the grantor's spouse). Following are the design features of the typical beneficiary-controlled trust:

The donor (i.e., parent or grandparent) is the grantor of the trust.

The child and his/her descendants are the beneficiaries of the trust. However, the child is the “primary” beneficiary of the trust during his/her lifetime and, therefore, the child’s needs take priority over the needs of his/her descendants.

The trust has two trustees — the primary beneficiary as the investment trustee, and an independent trustee as the distribution trustee. The independent trustee can be the primary beneficiary’s friend, trusted advisor or a financial institution.

The primary beneficiary has the power to remove and replace the independent trustee from time to time, thereby maintaining the beneficiary-controlled feature of this trust design.

The trustees can provide the beneficiaries with income and principal as needed for their health, education, maintenance and support.

The trust agreement allows the trustees to purchase assets without remuneration for the primary beneficiary’s use and enjoyment, such as vacation homes, artwork, jewelry, etc.

The primary beneficiary can be given a limited power of appointment, exercisable during life and/or at death, in favor of anyone other than the primary beneficiary, his/her creditors, his/her estate or the creditors of his/her estate. This allows the primary beneficiary to "rewrite" his or her trust for the next group of beneficiaries.

At the primary beneficiary’s death, to the extent the limited power of appointment is not exercised, the assets remaining in trust pass to his/her children, in equal shares, but in further trust. The grandchild now becomes the primary beneficiary of his/her separate trust, which benefits the grandchild and the grandchild’s descendants. And, to the extent of the grantor’s generation skipping tax exemption —which is currently the same as the estate tax exemption — the trust property passes estate tax free.

This "regime" is repeated for each successive generation for the maximum period permitted under state law.

Beneficiary-controlled trusts can be created at death as part of the grantor’s living trust, or can be used in irrevocable trusts, including irrevocable life insurance trusts. In addition, trusts created during the grantor’s lifetime can be designed as so-called “grantor” trusts. With a grantor trust, the grantor is responsible for paying the trust’s income taxes. Thus, the trust grows income “tax free”. In essence, the grantor’s payment of the trust’s income taxes is a tax-free gift to the beneficiaries of the trust. In short, a beneficiary-controlled trust should be considered whenever it is worthwhile to protect beneficiaries from creditors, divorcing spouses and estate taxes.

In part two of this series, we’ll discuss how to avoid the costs, delays and publicity associated with probate in the event of death or incapacity.

About the Author

Julius H. Giarmarco, Esq. is a partner and heads up the firm's Trusts and Estates Practice Group. Julius received his law degree (J.D.) from Wayne State University, and his master of laws (LL.M.) from New York University. His primary practice areas include estate planning, business succession pla... More